What’s behind the global sharemarket rout? Maley

Sharemarkets plunged wildly overnight as investors worried that central banks in the major developed countries would not be able to prevent the outbreak of a new global recession.

Financial markets have realised that the major political achievements of the past three weeks – the eurozone’s latest bailout of Greece, and Washington’s debt ceiling deal – have done nothing to improve the bleak global economic outlook.

The US economy is faltering, as existing government stimulus programs taper off and the payroll tax break comes to an end. If anything, Washington’s debt deal has worsened the outlook. Some economists estimate that fiscal tightening is likely to shave about 1 percentage point off already stagnant US economic activity next year.

The eurozone, which is advocating a vigorous dose of austerity for its debt-laden members, is likely to see an even harsher decline in activity. The two largest eurozone countries, Germany and France, will both tighten fiscal policy in 2012, while harsh austerity programs will tip some of the southern eurozone countries into recession next year.

And even the Chinese growth engine is slowing slightly, as authorities battle with rising inflationary pressures which threaten to ignite social unrest.

The problem is that governments in most developed countries have little option but to start embarking on a process of fiscal cut-backs. Years of deficit spending have left them with hugely bloated budgets, and soaring debt levels. As a result, they are under pressure to rein in their budget deficits, at a time when their economies are in desperate need of further stimulus.

Increasingly, investors are wondering if the central banks in the developed countries will be able to provide sufficient monetary stimulus to boost demand. But with interest rates already close to zero in most developed countries, the options for monetary stimulus are limited.

Overnight, European Central Bank boss Jean-Claude Trichet said the bank would again start buying government bonds. But markets were immediately discouraged because the central bank signalled that it only intended to buy Greek, Portuguese and Irish debt – countries that had already received bailouts. Investors, who are desperately worried about this week’s sharp rise in Spanish and Italian bond yields, were hoping the ECB would step in and aggressively buy Spanish and Italian bonds in order to stop yields from climbing even higher.

Meanwhile, hope is waning that the US central bank will commit to a new bond-buying program at next week’s meeting, because of fears that further monetary stimulus will fuel inflation.

When the US Federal Reserve launched its controversial $US600 billion bond-buying program last year, inflationary pressures were muted. Since then, inflationary pressures have built up, with consumer prices rising at 3.1% in the second quarter.

What’s more, many economists believe that the Fed’s bond-buying program – dubbed QE2 – actually undermined the US economic recovery. They argue that QE2’s only achievement was to spark a rally in risk assets, particularly in equity markets and commodity prices. However, higher commodity prices led to higher inflation. Faced with rising food and petrol prices, consumers had no choice but to cut back spending on other items. Given that the US consumer accounts for 70% of the economy, this quickly translated into a weakening economy.

What’s more, even the rally in equity prices has proved temporary. Some analysts say the current slump in share prices merely reflects the fact that the market has had to wean itself off the liquidity boost provided by QE2. In fact, they say, the market slumped in April 2010, shortly after the first asset-buying program – QE1 – came to an end.

As a result, the mood in the markets has become increasingly despondent as investors now fear that efforts by central banks to stimulate the global economy will prove futile. The global economy is in desperate need of increased fiscal stimulus. The tragedy is that no major economy is in a budgetary position to provide such stimulus.

This article first appeared on Business Spectator.